A Few Measured Words About Volatility
By Janet Ellen Hill

With the stock market’s recent wild ride—up one day, down the next five—we’ve been hearing a lot about volatility, which is a polite way of referring to investors’ nervousness. Investors may think volatility indicates a problem, but many analysts believe the opposite: that increased volatility in the markets is a preface to signs of a rebound.

In layman’s terms, volatility can be likened to car insurance premiums that increase along with the likelihood of high-risk situations, such as an insured’s poor driving record or if the car will be kept in an area with a regular incidence of theft.

Volatility is measured by the Chicago Board of Options Exchange (CBOE), primarily through the CBOE Volatility Index (VIX) and, to a lesser extent, the CBOE Nasdaq Volatility Index (VXN) for technology stocks. The VIX tracks the speed of stocks’ price movements in the S&P 100; the VXN tracks the same in Nasdaq 100 stocks. Both indices take a weighted average of the estimated volatility of eight stocks on a particular index. Both are calculated every 60 seconds over the CBOE’s trading day, recording a great deal of fluctuation.

The VIX is mostly affected by put activity, which is the practice of buying 30-day index options that protect investors from losing big in the market. When stock prices tank, investors bid on puts to preserve their investments. Higher prices for these options increase the level of the VIX. But purchasing these options does not ensure a sure thing; buyers have to be careful that they don’t obliterate a market’s move in their favor because they paid too much for these options.

The VIX usually fluctuates between 20 and 30 percent. This percentage measures the level of unpredictability that the market would have to undergo over the next month to make the current index option prices achieve a fair market value. Anything under 20 percent is considered low and an optimistic sign—usually time to sell. A VIX over 30 means there’s pessimism in the market, so it’s a good time to buy, as stock prices will be lower.

Seasoned traders who monitor the swings and arrows of the market’s outrageous fortunes usually pump a lot of money into stocks and index options when the VIX is high. Conversely, when the VIX is low, it usually indicates that investors believe the market will head higher. This, in turn, can trigger a market selloff as these speculators try to unload their holdings at premium prices.

In previous market crises, the VIX has spiked high during intraday trading, but has tended to close below 50 percent, with buyers rushing in to capitalize on the lower stock prices. During the peak of the 1998 market crisis, the VIX spiked as high as 60.63, but closed only as high as 48.56. Since the terrorist attacks in September 2001, the VIX has pretty much ended the day in the 40s. Its highest intraday spike during this period was just over 57 percent, but it had never breached a closing higher than 49.04 until this July 23, when it closed at a high of 57 percent.

July also saw the VIX’s highest levels since after September 11. The last time the VIX closed higher than 50 previous to this was in November 1987, at 55. Consider that the VIX spiked to its all-time high of 172 percent and closed just north of 150 on the Black Monday crash in October 1987, and this summer looks positively mild by comparison.

Historical data has shown that wild tremors in the market precede a change in the market’s direction. A high VIX appears just before a market rally, and a low VIX usually augurs a slide. If this wisdom holds true, we should see a slow rise or at least some stabilization in the market’s levels over the next few weeks. The late July rally helped all three major indices make minor gains after weeks of decline.

Some analysts say that because of these factors, the market is probably bottoming out right now. They do, however, temper this opinion with caution due to any further disclosures of corporate finance malfeasance.

Bearish naysayers, however, repeat the mantra that past performance is no indication of future return. They argue that any value to the VIX’s historical behavior has gone out the window since the market is fighting too many entrenched factors that are impeding its health, including the faltering economy, investor mistrust of corporations, and continued fear of terrorist attacks. They contend that too many variables at one time may make bullish optimism premature. Some even blame 24/7 access to financial news via cable and the Internet for enabling volatility, as people can watch the market move in front of their eyes.

Regardless, trying to predict the markets has always been a gamble. And as recent events have proven, there is never any guarantee they will move in a logical pattern, thus throwing all bets off.

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Janet Hill is a financial consultant practicing in Salt Lake City. She offers investment and senior financial planning as a registered representative of Commonwealth Financial Network—a member firm of the NASD/SIPC. She can be reached at janetellen@meridianmagazine.com.

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